Archive for July 11th, 2008

Fiscal stimulus guys need some behavioral economics lessons

July 11, 2008

In Feb 08, US passed a law to provide fiscal stimulus to the households. In May-08, the stimulus started working. The effects of this recent stimulus will be known later but it is important to understand how previous such stimulus worked.

San Fransisco Fed conducted a symposium on the same and here is a summary of the findings. It has some very interesting findings. First why fiscal stimulus which is a discretionary measure.

Until recently, the consensus view in mainstream economics was that such countercyclical discretionary fiscal policy actions were undesirable and/or ineffective. However, in the last few years, this consensus has unraveled and perhaps even begun to converge upon the opposite viewpoint, namely, that discretionary countercyclical fiscal policy can be effective and potentially more timely than monetary policy in counteracting the harm of economic downturns.

As recent crisis has not led to a severe downturn, what is the rationale for the stimulus?

First, it is now widely recognized that economic agents (consumers, workers, investors, firms, etc.) are quite limited in the extent to which they save and borrow to smooth consumption over time. Such smoothing behavior would tend to mitigate the effectiveness of temporary fiscal stimuli.

Second is the recognition that, while monetary policy’s effects on the economy come at a substantial lag, the impact from prompt fiscal policy actions may be more immediate.

I had pointed to the second in my report.

As far as impact of fiscal stimulus is concerned the central question is what do people use it for? For consumption or reducing their debt levels?

In this aspect the note points to two things. One, when asked people say they would pay off their debt first. Second, the actual outcome is different and people do pay their debt initially but then start splurging and come back to previous debt levels. 🙂

People actually go through emotions and will reduce their debt intiially but after some easing of debt, will get happier and again splurge expecting bad times not to come again.

I am actually thinking why not have some behavioral economics fixes to the stimulus package. . With such low savings in US, if people simply splurge the stimulus it might perk up the economy temporaily, but overall the debt burdens don’t reduce and the problem stays unresolved.

The fiscal stimulus people need some behavioral economics lessons to understand the way people behave and then make cheques that first pay off their debts and then remaining used for the splurge. Otherwise, we are back to square one.

Assorted Links

July 11, 2008

1. WSJ Blog points to Fedspeak – Bernanke, Stern (not a speech)

2. ASB points to fear of derivatives

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